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Cisco Plans Big Push Into Server Market

SAN JOSE, Calif. — Within the next few months, Cisco Systems, the largest maker of networking equipment, plans to release a product that threatens to shake up the technology industry and put the company on a collision course with traditional partners like Hewlett-Packard and I.B.M.

The product — a server computer equipped with sophisticated virtualization software — is a bold but risky move by Cisco into an unfamiliar, intensely competitive market that typically produces far lower profits than Cisco makes from network gear. But it reflects the company’s ambition to grow beyond its roots as the so-called plumber of the Internet to offer everything from instant messaging software to digital stereos.

For years, Cisco remained content to sell the switches and routers that direct the rivers of data flowing between computing systems. It dominates that market, making most of its $40 billion a year in revenue, and 65 percent gross profit margins, from such products.

The other major makers of computer hardware, including H.P., I.B.M. and Dell, have enjoyed a mutually beneficial relationship with the company, which is based in San Jose, Calif.: Cisco sells networking gear, while they sell personal computers, servers, storage systems and software.

“This will be the most important and most talked-about product of the year,” said Brent Bracelin, a hardware analyst for Pacific Crest Securities. “There will be massive competitive reactions from both I.B.M. and H.P., and we expect this will lead to a new wave of industry consolidation.”

Cisco executives played down the potential for serious conflict. “We see this not as a new market, but a market transition,” said Padmasree Warrior, the company’s chief technology officer. “Any time there is a major transition occurring, there will be large companies that have to compete in some areas.”

The technology driver behind this transition, according to Cisco, is virtualization software.

Over the last decade, virtualization software has experienced a meteoric rise. Virtualization products let companies run numerous business applications, rather than just one, on each physical server, allowing them to save electricity and get more out of their hardware purchases.

Recently, however, virtualization technology has started to have a more significant impact on business computing systems as a whole. New tools developed by VMware, the market leader, make it possible to shuffle business applications around a data center just by pointing a computer mouse at an icon on the screen. The mobility of the software has broken some of the traditional, linear connections among computers, storage systems and networking hardware.

As a result, companies like Cisco see an opportunity to produce a new, potentially disruptive class of hardware and software management systems that span an entire data center. With customers looking to manage their data centers as a single entity rather than separate units, the world’s largest technology companies must now fight to secure the most prominent, central position possible.

Cisco’s newfound aspirations stretch well beyond the $50 billion server market to include management software and possibly even storage.

“Our vision is, how do we virtualize the entire data center?” Ms. Warrior said. “It is not about a single product. We will have a series of products that enable us to make that transition.”

Cisco could show off the first of its new systems as early as March. The company would not disclose the exact nature of the product, although people with knowledge of Cisco’s plans said it would sell a server bundled with networking hardware and virtualization software from both Cisco and VMware.

Photo

We see this not as a new market, but a market transition, said Padmasree Warrior, the companys chief technology officer.Credit
Peter DaSilva for The New York Times

Rather than working as a general purpose system, the Cisco product will cater just to virtual applications. (Cisco owns close to 2 percent of VMware, a public company that is majority-owned by EMC, a maker of computer storage systems.)

Cisco’s diversification into the server market is fraught with risk. Cisco boasts gross profit margins of close to 65 percent, while companies selling basic servers tend toward gross margins closer to 25 percent on those products.

Ms. Warrior maintained that by bundling various hardware components with software, Cisco would earn higher profits than are typical for servers. But Wall Street remains skeptical.

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“It will certainly be a challenge for Cisco to get the new products to the same margin levels as its current products,” an analyst with Signal Hill, Erik Suppiger, said.

At best, analysts estimate, Cisco could obtain 50 percent gross margins with the server product. Such a figure, combined with Cisco’s probable modest start in this new business, would not affect its bottom line in the near term. Eventually, however, Mr. Suppiger and others say the move could lower Cisco’s overall profitability and change how investors view the company.

Perhaps more significant over the long term is the alteration of Cisco’s relationship with its longtime allies.

Mr. Bracelin expects I.B.M. and H.P. to consider acquiring networking start-ups and begin developing products similar to Cisco’s forthcoming system. They are also likely to direct business to other networking companies, like Juniper Networks and Brocade.

However, Cisco may have little choice other than to invade its rivals’ turf. Its core business is slowing, and for the company to meet Wall Street’s demands for growth, it must look to new lines of business.

Besides, its competitors are eyeing Cisco’s lucrative networking business for themselves. When Carleton S. Fiorina was chief executive of H.P., she sat on Cisco’s board, and her executive team encouraged H.P.’s sales force to promote Cisco products ahead of H.P.’s own ProCurve networking gear.

Under H.P.’s chief executive, Mark Hurd, that strategy ended. H.P. has made ProCurve a crucial piece of its growth strategy, priding itself on undercutting Cisco’s prices. With gross margins of close to 50 percent, ProCurve stands as one of H.P.’s most profitable businesses, second only to printer ink.

I.B.M., meanwhile, has long had a strong relationship with Brocade around storage networking products, and I.B.M.’s labs are working on their own networking hardware projects.

H.P. and I.B.M. declined to comment for this article.

Cisco dismisses the suggestion that it is fomenting war with longtime partners. The company is merely adjusting to a change in technology, and the other companies will do so as well, according to Ms. Warrior.

Cisco already battles Microsoft, another longtime partner, in the market for collaboration software that helps workers communicate on projects. In addition, Cisco sees opportunities in the consumer realm, playing off the home networking products it acquired through the purchases of Linksys and the set-top box maker Scientific Atlanta.

With close to $27 billion in cash on hand, Cisco could buy its way deeper into the data center as well, perhaps through an acquisition of VMware or even all of EMC, analysts say.

“Everybody is trying to get to the same point in the future,” said James Staten, an analyst at the research firm Forrester. “It’s inevitable that as they all get larger, they start crossing over into each others’ territory more and more.”